It’s Not Just Tax Rates: The Size of Government Matters

by Veronique de Rugy

Former president Bill Clinton hit the morning shows on Sunday and Monday. The purpose was mainly to highlight his Clinton Global Initiative meeting in New York this week, but he also used the opportunity to remind people that the economy won’t suffer from letting marginal tax rates creep back up to the pre-Bush-tax-cut levels. His evidence: The economy was doing well during his presidency in spite of the 39.6 percent top marginal rate on income.

To be sure, the economy was doing well in the nineties, even with higher marginal rates. However, the burden of taxation isn’t the only factor in the health of an economy. A factor consistently overlooked by those calling for higher marginal tax rates is the size of government as measured by its spending.

According to OMB’s historical tables, when Clinton left office, government spending as a share of the economy was 18.2 percent. In FY 2005, the government spent $2 trillion. This year, government spending as a share of the economy is 25.3 percent, and real spending has reached $3.3 trillion. That’s significantly larger than when Clinton left office. 

Why does the size of government matter? Because as government spending grows, the private sector tends to shrink. In 2010, new research from Harvard Business School showed effectively that federal spending in states causes local businesses to cut back rather than grow. In other words, when government spending grows, the private sector shrinks. Key findings in the study:  

The average state experiences a 40 to 50 percent increase in earmark spending if its senator becomes chair of one of the top-three congressional committees. In the House, the average is around 20 percent.

For broader measures of spending, such as discretionary state-level federal transfers, the increase from being represented by a powerful senator is around 10 percent.

In the year that follows a congressman’s ascendancy, the average firm in his state cuts back capital expenditures by roughly 15 percent.

There is some evidence that firms scale back their employment and experience a decline in sales growth.

This is understandable because the government depends entirely on the private sector for its resources. In my mind, the gigantic growth in government of the last ten years also explains why the economy didn’t respond as well as it could have, especially in the longer run, after the implementation of the Bush tax cuts of 2003 (not the 2001 one, which in essence was Keynesian government spending). Sadly, under President Bush, government spending in real terms grew by 60 percent over the course of his two terms. The best tax cut can’t compensate for this explosion in government spending. By contrast, Bill Clinton had slightly higher marginal rates, but real government spending only grew by 12 percent over his two terms.

The size of government matters. Government spending, and how much of the country’s wealth it consumes, matters dramatically. I wish that people calling for higher tax rates on anyone and using evidence from the 1990s would recognize that fact.

Also, I am stunned by the way the president and many liberal pundits tend to talk about tax policy. Listening to them, one would think that the role of tax policy is to milk as much revenue as possible from taxpayers — independent of the performance of government or the desires of the people who consume the services (and those who pay for them). This vision explains the constant attempt to extract more and more money from those who may protest the least — such as higher-income taxpayers.

I would suggest that a better way to think about tax policy is to think about collecting the level of revenue necessary for the government to deliver essential public services. And yes, this vision does require us to identify what essential public services are rather than assume that the government should be in the business of, well, everything.

President Clinton should be proud of his legacy — in particular, he can be proud of his record on the size of government. But it is absurd for him to use it as evidence that higher marginal rates won’t be harmful to the economy. Rather, his legacy is evidence that keeping government spending relatively in check allowed the private sector to produce wealth, in spite of the increase in marginal tax rates.